Thursday, March 6, 2014

March-April 2014 Outlook: Best Picture

The year got off to a rocky start as the impending end of the Fed's
quantitative easing program led to a minor retrenchment in the markets. After a
blockbuster year for stocks in 2013, major US indices fell in January for the
first time in four years. Emerging markets took the brunt of the tapering
impact, exacerbated by political problems in places like Turkey, Venezuela, and
most recently the Ukraine. Some worse than usual winter weather in the US piled
on (literally and figuratively) leading to some re-pricing of risk. Three US
Treasury note auctions in last week of February showed strong demand,
indicating the bond market also has some reservations about the economic
outlook.

But investors cast aside early doubts, and markets came back with guns blazing
like an action movie hero in the second act. The S&P500 dipped only single
digit percentages in January before rebounding smartly, and European indices
largely followed suit, though Japan's Nikkei and many emerging market indices
are lagging behind.

Whatever caused the stock market swoon earlier this year, investors have chosen
to accentuate the positives like solid Q4 earnings reports, and eliminates the
negatives like slow retail sales and industrial production data. Much like the
Academy Awards broadcast , the markets only really seem interested in
presenting the best picture. Some new MacGuffins may yet emerge to reverse plot
of the market's risk-on sentiment, but so far even the Russia heavy (Putin) has
failed to changed the course of the story.

American Hustle

In the US, the major question continues to be how markets will respond to the
Fed tapering quantitative easing. The Fed has taken the last year to carefully
frame tapering not as the beginning of the end of accommodation, but merely as
the withdrawal of additional stimulus, and has indicated that barring a
disruptive new trend in the data, the QE rollback will stay on its $10B per
meeting pace and wrap up in late 2014. So far US markets have bought in to that
script, continuing to set new record highs on the S&P and Dow, but as the
end of QE approaches there could be some renewed jitters, and the equities
could get more skittish. Already some chartists note that the most recent highs
are getting narrower in breadth, based largely on a few outsized winners (like
Tesla), and the doomsayers keep pointing to stock index charts that suggests an
eerie similarity between the last year and the lead up to the 1929 crash.

Brazen predictions aside, the end of QE is being absorbed without too much
tumult, but eventually forward looking markets will start to model what comes
after QE has ended. Fed Chair Yellen and her cohorts have stated publically
that they are looking to retool forward guidance, taking it away from
quantitative measures like the 6.5% unemployment threshold and back to the more
qualitative guidance seen pre-crisis. Given the broad range of opinions
expressed by FOMC members on this subject, it could reasonably take the rest of
the year for the Fed to craft their new forward guidance, but we will continue
to see glimpses of its evolution in "rushes" of Fed speeches and
minutes in the months to come.

Things are clearer than they have been for a long time on the US fiscal front.
After producing nothing but political cliff hangers over the last few years,
Washington has finally made some progress toward reducing uncertainty. Congress
has cleared the decks for 2014, settling the debt ceiling issue as well as
funding the government through the mid-term elections and into early next year.
The politicians are now discussing less pressing issues like raising the
minimum wage and extending unemployment insurance (UI). The minimum wage is a
perennial football in Washington, while the expiration of UI benefits for
millions of Americans could hurt consumer spending at a sensitive moment of the
recovery, and play more havoc with unemployment figures that have already been
skewed by structural changes that have noticeably shifted the workforce
participation rate.

Aside from the jobless rate falling faster than expected, US economic data has
been largely disappointing for a couple of months. It is yet unclear, however,
whether its root is a cyclical slowdown or just that the data has been tainted
by the worst winter weather in decades. The weather may give us a free pass for
Q1, but heading into the spring the data needs to shake off those temporary
factors.

A worst case scenario for the Fed would be payroll and housing numbers failing
to pick up in the spring, testing the central bank's resolve to finishing
tapering. Though the FOMC policy statement leaves nominal flexibility, bank
officials have made it clear that it would take a significant outlook change to
deviate from the current path of tapering. So if the cuts in QE are paused,
then the market reaction could be exaggerated. Central bank officials are also
keenly aware that a mid-course shift in tapering could further chip away at Fed
credibility that has been eroded by dodgy economic forecasts and the
communications bobble in mid-2013 that led to the 'taper tantrum'.

A spring thaw in US data could be led by a snap back in housing. Already the
January new home sales reading came in at a 7-month high, despite the cold
weather woes. If other indicators like building permits and existing home sales
start to confirm an improvement in the housing market, they could in turn lead
other economic data higher, perhaps shaking the winter malaise off of consumer
spending and industrial production numbers. Better numbers in the next two
months could still salvage a decent rebound in growth when the advance Q1 GDP
data is released on April 30.

Brussels Buyers Club

After many years of struggle, the European economy is starting to show some
renewed signs of life. Unemployment has stabilized, Ireland is exiting its
extraordinary support program followed closely by Portugal, and there are no
new sovereign financial crises on the radar. Sovereign bond yields between
peripheral nations and the German bund are at their narrowest in years,
indicating cohesion is returning to the euro zone after it was nearly spun
apart. Within the zone the only current political drama is in Italy, where an
ambitious young party boss has pushed out Prime Minister Letta, though it
remains unclear if this will be a setback for Italy's economy which just scored
its first quarterly growth reading in over two years.

Lately, the chief concern for Europe has been persistent low inflation. The
European Central Bank, which has tried get out in front of some previous policy
hazards, has had a more difficult time taking a decision on this matter.
Officials have been jawboning the issue, never missing a chance to note
"inflation expectations are well anchored", but they seem to be
hesitant to pull the trigger on the next evolution of policy accommodation.

The latest reports, however, indicate a move could come as soon as the March
6th policy meeting, when new staff economic projections through 2016 will be
released. It appears that with inflation sitting on the lower boundary of its
comfort zone, there is a growing consensus at the ECB that preemptive action is
needed again to head off a crisis moment before it erupts. Last year a move to
negative deposit rates got a lot of discussion, though it had some detractors
worried about unintended consequences. Indications now are that a small cut in
the main refi rate is under consideration, or that the central bank may instead
elect to end the so-called sterilization of bond purchases, the practice of the
ECB selling an equivalent asset for every purchase it makes under its Securities
Markets Program (SMP). Tight liquidity in the euro zone has contributed to
numerous sterilizations failing recently, which appears to suit the ECB's ends
given that it wants to boost the money supply. With even the hard-line German
Bundesbank now ostensibly supportive of ending sterilization, ECB President
Draghi has the power to transform the SMP into quantitative easing in all but
name. A green light for ending sterilization at the March or April meeting
would release approximately 180 billion euros, almost doubling the amount of
excess liquidity in the euro zone financial system, and could achieve the added
benefit of lowering the euros exchange rate.

At the next couple of ECB policy meetings Draghi will also likely continue to
discuss ideas for a new LTRO-style operation that would target increased
lending to the real economy to boost growth and inflation rather than for bank
capital formation as the original LTROs fell into. Such a program still has
numerous technical and political hurdles to clear, but Draghi should keep it in
his rhetorical toolbox as he works to reinforce euro zone stability.

Though the euro zone and EU are restoring a sense of stability, they don't have
to look too far beyond their borders for fresh headaches. The upheaval in the
Ukraine has revived the specter of the Cold War as the populace struggles
between the allure of Europe and its historic ties with Russia to the east.
Russian President Putin tried to force the issue by mobilizing troops, but the
threat of international sanctions and an immediate double digit drop in the
Russian stock market seemed to give Mr. Putin pause. He quickly wound down the
"military exercises" in the region around Ukraine and suggested that
military force would be used only as a last resort in defense of Russia's
interests in Crimea. For the moment, tensions have eased, though a Crimea
referendum on its status within the Ukraine set for March 30 may provoke a more
violent clash if Ukraine asserts its territorial sovereignty and refuses to let
go of the Black Sea holdings that Russia ceded to it sixty years ago.

The Dragon of Wall Street

As China continues its effort to engineer a shift from an export led economy to
one driven by consumer demand, the world's second largest economy is experiencing
some growing pains. A wave of subpar manufacturing data continues to raise
questions about the nation's economic vitality, though the latest trade balance
number was encouraging with higher than expected imports and exports. The
official 2013 GDP tally came in at 7.7%, two-tenths ahead of the official
target, but the weakest growth in 14 years.

The National People's Congress (NPC) meeting the first week of March (starts
3/5) may set the tone for the economy in 2014. The meeting will produce the
official macro targets for the year as well as set the agenda for economic
reform efforts. Most analysts see the central government maintaining the
official growth target at 7.5% for 2014, necessary to keep on pace for
achieving the decade-long goal of doubling the economy through 2020.

Others see a different outcome. Ahead of the event, a government-affiliated
think tank called the State Information Center proposed lowering this year's
target to 7% as a signal to local governments to relax their single-minded
focus on growth, trim back unnecessary investments, and address economic
reform. In November, Premier Li Keqiang indicated that 7.2% GDP growth is
require d to create the 10 million jobs annually needed to keep urban
employment levels steady. Additionally, one Chinese news report indicated that
nearly two dozen provinces would lower their GDP targets this year while only
two looked to raise them. Given this, there is some speculation that China's
government could set the growth target at 7% or couch a 7.5% number as a
"projection" rather than as a firm target.

A lower GDP growth goal could be taken as a signal that Beijing is getting more
serious about tackling the economic reforms needed to address international
jitters about exploding local government debt, nearing $3 trillion in mid-2013.
The NPC could also announce steps to improve and structure local government
access to the municipal bond market to replace ad-hoc funding through short
term bank loans.

[*Note: since the time of writing, the NPC has announced that for the
third year in a row the GDP target will remain at 7.5%, though the 2014 target
was labeled as "elastic", which one National People's Congress deputy
said was aimed at "changing the mindset of GDP worship" amongst local
level officials].

China's master planners have also started moving the currency in unexpected
ways. The yuan has dropped steadily in 2014, falling over 1% against the
greenback in a few weeks after appreciating 10% over the last three years.
Analysts say the People's Bank of China is engineering the reversal in an
effort to punish currency speculators and to squeeze out hot money inflows,
which amounted to something like $150B last year. The concern appears to be
that the inflows of foreign capital could complicate the government's latest
economic reform efforts coming out of the NPC meeting. Reports are that the
move has had the unintended consequence of flooding China's money market with
local currency and pushing down unofficial lending rates, contrary to the
governments goal of keeping borrowing costs elevated.

Chinese corporate debt levels have pushed to record highs, ending 2013 at $12T
or about 120% of GDP, which has raised some concerns about the potential for
instability in Chinese financial markets. Until now the government in Beijing
has facilitated bailouts of every major business venture that has threatened to
default, but press reports have suggested that growing corporate debt levels
will obligate some future defaults and an acceleration of domestic restructuring.
When the government chooses to allow a firm to default it may lead to some
retrenchment in Chinese financial markets as investors learn that they cannot
assume they will always be made whole.

The moment of truth may have just arrived in the form of Shanghai Chaori Solar
Energy Science & Technology [002506.CN], which just announced that it will
not able to repay in full 90 milion yuan of interest on its corporate bond.
This amounts to the first default on publicly traded debt in modern Chinese history,
and one analyst has already suggested that Chaori's default could be China's
"Bear Stearns moment". This may conjure some short term uncertainty,
but ultimately allowing some failures will improve Chinese markets, prompting
investors to make more studied choices when deploying capital.

12 Years a Malaise

In neighboring Japan the bull case is quite simple: more of the same. The
Nikkei exploded higher last year on optimism about Prime Minister Abe's radical
turnaround plan that snapped the nation out of a decades-long economic coma.
The next potential stumbling block Abe's eponymous scheme is an increase in the
consumption tax, meant to chip away at the nation's huge deficit, and set to go
into effect at the start of the new fiscal year on the 1st of April. Japanese
consumerism could feel a chill in as the tax on most products and services
rises from 5% up to 8%, with another two-percent increase slated to occur in
late 2015. Government and central bank officials seem to be quite confident
that their stimulus plans will lead companies to boost the wages of their
workers enough to offset the sales tax increase. Indeed many of the country's
biggest manufacturers have already indicated a willingness to raise worker base
pay for the first time in years, but if wage gains don't materialize on a
nationwide scope it could pose a risk to the Abe administration in politically
fickle Japan.

Gravity

What goes up must eventually come down, though it matters how you come down as
Sandra Bullock's character in the motion picture Gravity can attest. In
a world of political crises in eastern Europe, lackluster economic data in the
US and China, uncomfortably low inflation in the EMU, and the first big test of
the Japanese reflation planwhat does it all amount to? So far not enough to
erode the risk-on sentiment that is keeping this five-year-old bull market
going.

That could change with a bad turn of events like US data staying tepid once the
weather excuse is gone, or a shooting-war erupting in Ukraine. More likely
though, this season the markets will mirror the movie business dumping
forgettable bombs on the public in the first few months of the year, but then
bringing out the sequels and blockbusters in the spring. If things go well, the
Wall Street crowd could be lining up to see 2013: Part II.